Herbalife Ltd (HLF US) disclosed that they were in recent buyout talks with a private–equity firm, however the deal ultimately did not get completed. In its place, Herbalife will commence with a “modified Dutch Auction” self-tender to purchase $600 million shares of its stock at a price between $60/share to $68/share. In addition to the cash payout, all shareholders who tender their stock will also receive a “contingent value right” that would allow for an additional cash payment if the firm is acquired at a higher price than the $60-$68/share over the next two years.
Additionally, to ensure that the Dutch Auction reduces only the tradable street float, members of Herbalife’s Board of Directors, Herbalife executive directors and Carl Icahn have agreed not to tender their shares into the Dutch Auction. Herbalife has 93.6 million shares outstanding with 27.02 million shares owned by insiders (including 22.87 million shares by Carl Icahn), leaving 66.94 million shares of float. If the Dutch Auction gets fully tendered as expected, Herbalife’s float will be reduced by 8.82-10.00 million shares, and will drop down to 56.94 to 58.11 million shares.
Herbalife short interest is up $353 million, or 28%, for the year and is slightly above its year-to-date average of $1.62 billion. After declining for most of the third quarter, we are seeing an increase in short selling over the last week.
According to Pershing Square’s January 2017 annual report, their Herbalife short was approximately 9% of their AUM. With an AUM of $10.982 billion, Bill Ackman had an estimated $988.38 million short Herbalife position at the time of the Annual Report, or 18.60 million shares short (at HLF’s 1/26/17 stock price of $53.13). Considering Bill Ackman’s tenacious Herbalife short conviction and the fact that Herbalife’s overall short interest has not decreased below 2016 average short interest levels we can assume that he has not covered his position.
Over the last two days Herbalife’s 10.5% price move has added $153 million in mark to market losses to an already unprofitable year for short sellers. Shorts are now down $558 million in year-to-date mark to market losses, down 35.6%, which more than offsets last year’s $214 million in Herbalife short profits.
With Bill Ackman making up approximately 75% of Herbalife’s total short interest, Pershing Square’s estimated Herbalife loss over the last two days is $115 million and the hedge fund is down an estimated $419 million in year-to-date mark to market losses, after being up $160 million in 2016.
Herbalife’s proposed 8.8 to 10 million share buyback may actually squeeze Bill Ackman out of some of his shorts. With 24 million total shares already shorted in Herbalife stock, there are approximately 7 million shares left available to borrow. While not all the shares that will be tendered into the Dutch Auction are in stock lending programs and actively lent to short sellers, we can assume that a portion will come from lending programs or margin accounts. The need to return tendered shares to beneficial owners will result in a significant decrease in stock loan availability and numerous street-wide recalls. With Bill Ackman making up 75% of Herbalife’s total short interest, most of the stock borrow recalls will be directed his way. If the Dutch Auction is fully tendered, as expected, there is a good chance that Bill Ackman will be on the receiving end of 3-5 million shares of stock loan recalls.
In addition to a drastic reduction in Herbalife stock loan availability, the cost to borrow Herbalife stock will increase dramatically after the Dutch Auction. Herbalife stock borrow costs hit a 5 year high of 7% fee in 2014, but after a successful Dutch Auction, Herbalife’s stock loan availability will be significantly diminished. Stock borrow rates will spike much higher as borrow supply dwindles. When Herbalife’s excess stock loan availability disappears and lenders are forced to issue recalls in order to meet the settlement needs of its beneficial owners, borrow rates will increase. Depending on the amount of recalls that hit the street, and the increase or decrease in Herbalife short selling demand, borrow fees will climb to the 10% to 40% fee level.
If recalls and high stock borrow rates force short sellers to cover their stock, there may be a pre- and post- Dutch Auction short covering rally. Long Herbalife shareholders may be better off joining Carl Icahn and not tendering their shares and riding the post-corporate action buying wave to a higher stock price than the auction tendered price.
At today’s 2% borrow fees, Bill Ackman is paying approximately $63k in daily financing costs for his open Herbalife short position, but when stock borrow rates climb to 10%-40% his borrow costs will increase to $300k to $1.2 million of stock loan financing cost per day. The increased borrow cost may lower his net of financing Alpha to unacceptable levels.
Herbalife’s proposed Dutch Auction may force Bill Ackman to cover some of his shorts due to recalls or he might have to cover some of his shorts due to prohibitively expensive borrow costs. While this will probably not become a fatal short squeeze for Bill Ackman, it will definitely be a firm Carl Icahn bro-hug.
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Managing Director Predictive Analytics, S3 Partners
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